Income investors face multiple challenges – dividend cuts, historically low yields, rising corporate defaults, and an uncertain property market. Francois de Bruin goes in search of sustainable income sources.
You don’t have to be drawing income to understand the power of compounding and the importance of having a reliable income stream within your portfolio. COVID-19 has made life harder for already yield-starved investors, and each asset class faces its own challenges.
With dividend income such a core staple of investors’ portfolios, let’s look at the equity picture first. Around $2 trillion was committed by listed companies worldwide in 2019.1 Since then, there have been headlines on dividend cuts, suspensions and withdrawals across a variety of sectors. The ten largest companies in the FTSE 100 are responsible for almost half of the UK stock market’s dividends: one third of that stream has been lost and several others moderated. Regardless of the rationale, those making cuts have tended to be penalised by investors.
Some companies are simply responding cautiously to what economists say could be the deepest recession on record. Others – like European and Australian banks – have had decisions taken out of their hands, as regulators have called for dividend freezes to strengthen balance sheets.
Regulatory pressure to freeze distributions from the European banking sector has had a significant impact. In May 2020, the dividend commitments put on hold by European banks made up almost half of the total announced so far.2 From an income lens, this has made Europe one of the most impacted regions, but the move is intended to ensure the pandemic does not spill into a broad financial crisis. (US banks have not been subject to the same regulatory intervention.) European insurers have also been guided to be prudent and temporarily suspend distributions; some have chosen to go ahead anyway.
Balancing capital efficiency and resilience is also causing a rethink among companies. Before COVID-19, accessing ultra-cheap debt to maximise pay-outs fuelled distributions; particularly in the US, where share buybacks reached record levels. This strategy could prove costly, as those that returned more to shareholders than they generated in free cashflow have found themselves with less cash, more debt and are less prepared for the downturn.
There are still companies positioned to benefit from secular growth trends
At times like these it can be difficult to focus on the long term, but it is worth remembering there are still companies positioned to benefit from secular growth trends. There has been standout performance from digital infrastructure, for instance, where companies operating data centres have reported record levels of activity as companies migrate activities online. As global data creation is expected to compound at more than 25 per cent a year until 2025, this is a theme with real momentum.3 Certain semiconductor producers, for example, which make everything from smart phones to cars and are considered to be essential businesses, have been able to operate through the lockdown.
Elsewhere, companies with defensive characteristics – in healthcare, utilities and consumer staples – also look well placed. Overall, around 40 per cent of global dividend payers fall into this category,4 so the opportunities are diverse, and many have unbroken dividend growth records going back decades.
Energy stocks have historically been big dividend payers, making them a favourite among income investors. They have been reluctant to make cuts, despite sharp reductions in energy demand and short-term profitability. Significant distributors like BP and Total have chosen to maintain dividends (see Figure 1); these companies are used to volatile commodity prices, and many have inbuilt resilience in their capital structures that allows them to take a longer-term view.
Figure 1: EMEA - Largest dividend distributors have mostly maintained dividends
Even so, Royal Dutch Shell’s historic dividend cut, its first in 75 years, has understandably caught the attention. Many of its peers in the oil and gas sector are expected to come under material stress, but time will tell whether the market ultimately places a higher premium on dividend track record over operational resilience.
The signals from the dividend futures market suggest investors are pricing in deeper dividend cuts than have been announced so far. But sentiment is volatile. For instance, Total’s 2020 dividend futures were at one stage pricing in a 45 per cent cut, but that retraced to 15 per cent after the company issued a reassuring earnings release pointing to capex being flexed, and ample cushion for the dividend.
EMD: A widening gap between winners and losers
It is not just equity income that is feeling the effects of the COVID-19 shock. The higher yields available on emerging market debt (EMD) have historically been attractive to income investors. However, the elevated yields on offer must be considered against a weakening outlook, as the deterioration in fiscal balances and reduction in cross-border trade may lead to credit events for some issuers.
Despite this, attractive opportunities exist in select countries and companies where credit metrics are likely to be able to withstand short-term weakening. Among the better placed sovereign issuers is Ukraine, which is pressing ahead with reforms that will unlock further IMF funding. Ivory Coast and Kenya have also been relatively swift to adjust budget spending and make financial projections available.
Conversely, certain ‘at risk’ countries such as Oman have suffered from poor fiscal policies for many years, and now face a difficult period. Risk is also elevated for the likes of Pakistan and Sri Lanka due to liquidity and solvency pressures.
Attractive opportunities exist where credit metrics are likely to be able to withstand short-term weakening
It is also worth noting that fundamentals for EM corporates have improved over the last couple of years and compare favourably to developed market issuers, with lower net leverage, higher interest coverage and higher cash levels. Default rates will increase but are likely to be significantly lower than in EM sovereign issuers – and perhaps even lower than in DM corporates.
Overall, the differentiation within the universe is becoming more pronounced. Attractive returns can still be found, but opportunities will be sparse. Selectivity has always been key in emerging market investing, but never more so than now.
Sustainable, real income
Infrastructure can provide a defensive foundation in a portfolio. Perhaps unsurprisingly, sectors showing greater resilience include non-discretionary services like power and utilities. Data transmission and storage assets also have utility -like characteristics, just like water or power networks, as data access has now become an essential public service. Conversely, there has been greater uncertainty in sectors experiencing major demand shocks; in transport for example (airports, toll roads, motorway service stations and ports.)
The resilience of infrastructure debt will be tested in the coming months. In the past, the debt has experienced less rating migration and lower credit losses than in equivalently rated corporate credit. While sudden revenue reductions may result in some technical defaults, liquidity will be key to prevent any payment defaults or debt restructurings. A few sponsors are being proactive and engaging with lenders early and acting quickly to assess how to manage any income shortfall. However, this approach is not widespread.
As with the financial crisis, the economic fallout from COVID-19 will lead to a reassessment of investment risk, particularly for demand-based assets, along with a greater focus on conservative deal structures, liquidity and probably lower asset pricing.
Long-income real estate is one sector that has historically performed well in difficult periods; benefiting from recurring, contractual leases that are less economically sensitive than other sectors. In past corrections, like the one in late 2018, listed property also outperformed global equities by a solid margin. With COVID-19, the response has been different so far, with the global real estate investment trust market markedly underperforming. By changing the way in which physical space is used, it has accelerated some structural changes that were already under way and altered the underlying income drivers.
For assets let to high quality counterparties – like those in the public-sector – the income outlook is broadly positive. Long-lease supermarkets also look well-placed, as ‘stay at home’ orders have increased demand for groceries. Further out, though, there may well be a continued shift towards online food ordering at the expense of physical store sales.
In other fields, COVID-19 has introduced new uncertainties. As the pandemic began to bite, many educational institutions shifted teaching online and closed facilities and accommodation, for instance. It is not clear how long social distancing might last, impacting take-up rates for the next academic year. Assets with university rental guarantees do give landlords some protection against short-term drops in occupancy rates, but it remains to be seen whether more students will ultimately choose online tuition.
We expect to see significant changes in a number of sub-sectors
Ultimately, we expect to see significant changes in a number of sub-sectors. In logistics, occupiers may seek to boost supply chain resilience and hold more inventory, which would be positive for demand. In offices, the shift towards home working might accelerate; we are also mindful of challenges in retail, where weaker retailers in secondary locations may not return at all as the shift to online retail accelerates. Impacts will depend on specific local factors, including the size and nature of stimulus and the type of recovery we see.
With absolute yields once again languishing near historic lows, demand for income persists. COVID-19 has introduced much greater complexity into the search but drilling into the detail reveals there are opportunities in various asset classes, some more unexpected than others. With careful management, it is still possible for investors to construct a resilient income stream so long as they are prepared to cast the net more widely.